It's been almost ten years since Congress decided to make most home sale profits tax-free. When the law changed in 1997, most tax advisers thought it would be safe for most homeowners to stop being meticulous in tracking the tax basis of their homes.

Your basis is the investment in the house that you subtract from the proceeds when you sell to determine the taxable profit. But, if the first $250,000 of profit is tax free for single people and a cool half million bucks for married couples, why bother tracking your basis? What are the chances you'd ever crack the tax-free barrier?

Well, more people are discovering the answer -- to their thrill and their dismay. Soaring home prices have pushed some homeowners' profits over the tax-free limits. It's great to make such a huge profit, but it's still painful to have to share part of it with Uncle Sam. If you're in this boat, it's important for you to reacquaint yourself with what counts toward your basis so you can hold the tax bill down to the minimum.

Your tax basis begins simply enough as what it cost you to buy the house. But it changes, quickly and often.

Advertisement

For example, when you buy a home, costs that can be included in the basis include title-insurance premiums, transfer taxes, property-inspection fees, utility-connection charges and amounts owed by the seller that you agree to pay, such as part of the real estate agent's commission. Get out your settlement sheets.

Then, as you own the home, the cost of capital improvements adds to your basis, too. A capital improvement is something that adds value to your home, prolongs its life or adapts it to new uses. Your basis includes what you pay for an addition to the house, for example, a swimming pool or a new central air-conditioning system. It's not restricted to big-buck items, though. A new water heater counts, as do an intercom, security system or new storm windows.

The cost of repairs, on the other hand, don't add to your basis. Fixing a gutter, painting a room or replacing a window pane are repairs rather than improvements.

When you sell a home, your profit is basically the net proceeds of the sale (selling price minus expenses, such as the agent's commission) minus your adjusted basis. Adjusted basis is what you paid for the house plus the cost of improvements, minus any casualty losses on the property you claimed while living there -- for fire or storm damage, for example.

The basis is also reduced by any gain from a previous home you rolled over into the house under the rules that applied before May 1997. Before the rules changed, homeowners could defer the tax on home-sale profit by buying a new home that cost at least as much as the one that was sold. Any profit on a sale that was not taxed was considered "rolled over" into the new house, to be taxed when that property was sold unless it was rolled over again. Each rollover held down the basis in the new home, which is why some sellers are now finding themselves with taxable profits.

If you have a taxable profit from a home sale, you report it on Schedule D, and be sure to use the special worksheet for figuring your tax bill so the 15% maximum capital gain rate applies to your home sale profit.